Financial advisers may focus on fortitude, but ‘risk capacity’ is more important

If you ever consulted a financial adviser or signed up for an online investment advisory service, you've no doubt heard that question. And if you suffered through the stock market’s roller coaster ride of the past few years, you’ve probably reconsidered your answer.

By asking about your emotional response to risk, advisers aim to determine how much uncertainty you can withstand when you make an investment. In plain English: Just how would you feel if your investment lost money and how much of a loss could you handle?

What's More Important Than Risk Tolerance

Gauging your risk tolerance is certainly important. After all, there’s no point in constructing a retirement portfolio bulked up with stocks if you're likely to crawl under the covers the first time the market takes a nosedive. But before taking a closer look at risk tolerance, I want to talk about something that’s even more critical, though it doesn’t get nearly as much attention: risk capacity.

Risk capacity is a measure of how much risk your finances can realistically absorb.

Think of it this way: An investment with a strong chance of losing $10,000 over the next year may be daunting. But it's more daunting to a 32-year-old woman with a new family and $30,000 in her 401(k) than it would be to a 60-year-old with $800,000 socked away for retirement whose kids have finished college.

“Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your goals,” writes Zvi Bodie and Rachelle Taqqu in Risk Less and Prosper: Your Guide to Safer Investing.

How to Measure Your Risk Capacity

The risk capacity calculus doesn’t start with the relative riskiness of stocks, bonds and cash, as you might expect. So put aside thoughts of your 401(k), mutual funds and the (miserly) interest earnings on your emergency fund in the bank.

Instead, you should focus first on the security of your employment income and your career’s financial prospects. To judge how much risk your household can absorb, look at the volatility of your earnings from work, the outlook for your future career income and your odds of becoming unemployed. Together, these three factors are a critical gauge. An understanding of these are what you need to construct an appropriate investment portfolio.

Let’s say your income is relatively stable and secure. If you can be relatively confident of earning a decent income and any spell of unemployment will likely be short, your household can handle more market risk — like a greater exposure to stocks — than someone with a less reliable income. With that in mind, you might invest somewhat heavily in stocks to help pay for retirement or another future dream, knowing that you can depend on your wages even if the market turns on you.

But what if your earnings vary significantly from year to year and the specter of unemployment is a constant worry? Maybe you’re a salesman on commission, a contract worker or an architect. In this case, you should consider a far more conservative investment portfolio. That might mean, for example, investing more in FDIC-insured bank accounts and high-quality, fixed-income securities, like Treasury bills and short-term corporate bond funds. This way, your safe savings will be there if that three-month computer-programming contract ends and you don’t have another one lined up.

How Your Family and Contacts Fit In

Your family ties represent another critical variable when you evaluate your risk capacity. Maybe you’re the low-earning member of your family, but you know your brother or spouse will backstop you in a pinch. That could mean you can afford to take more investment risks than someone without this kind of support.

The depth of your business network counts, too. These days about half of all job offers — and maybe more — come through informal channels: connections to friends, family and colleagues. So your risk of going a long time without work will be greatly reduced if you have a large, well-connected network.

The Role of a Rainy Day Fund

Your debt load and your preparedness for a financial emergency also play a role in your risk capacity. The less debt you have and the more money you’ve set aside in an emergency-savings rainy day fund, the more investment risk you can take. (The emergency-savings rule of thumb used to dictate that you set aside an amount equal to three to six months of your living expenses. But given the record levels of long-term unemployment, many financial advisers recommend having an emergency fund that would cover six months to one year of expenses.)

Of course, the risk capacity calculation involves judgment rather than certainty. Life has a way of upending reasonable assumptions about careers; technology is an unpredictable disruptor of industries. Still, thinking through everything from your income to your business networks will give you a sound foundation, one that will help you judge how much financial risk your household can absorb.

Where Risk Tolerance Fits In

So where does risk tolerance fit in?

Once you’ve determined your capacity for investment risk, that’s the time to consider your psychological and emotional ease with the kind of portfolio that would suit your risk capacity. This is when you might want to take one of those risk tolerance quizzes. One good one is the Investment Risk Tolerance Quiz devised by personal finance professors Ruth Lytton at Virginia Tech and John Grable at Kansas State University.

I confess, however, that I’m not a huge fan of these questionnaires in general. The gap between answering hypothetical, multiple-choice questions on your computer and actually living with the consequences of your investment choices is enormous.

To complicate matters further, remember this: Risk tolerance isn’t static. As Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, wrote: “Few people feel the same about risk every day of their lives. As we grow older, wiser, richer, or poorer, our perception of what risk is and our aversion to taking risk will shift, sometimes in one direction, sometimes in the other.” So if you plan to take a risk tolerance quiz, take it again from time to time in case your risk tolerance changes.

We’ve lived through a decade marked by two bear markets, two recessions, a global credit crunch, disappointing stock market returns and unexpectedly large bond market gains. You probably learned a lot about your reactions to abrupt changes in market values during that time. If so, use the insight and knowledge you’ve gained to your future benefit.

I think this story about J.P. Morgan, the 19th-century financier, does a great job of illustrating an experience-based assessment of risk tolerance:

The tale goes that a man was in a panic after putting all his money into the stock market. He wanted to be rich, but he knew that if the stock market crashed he’d be financially ruined. He couldn't sleep. One day, seeing the imposing figure of J.P. Morgan on a street, he summoned up his courage and asked, "Mr. Morgan, I've invested all my money in the stock market and I can't sleep. I'm a wreck. What should I do?" Morgan replied, "Sell down to the sleeping point."